Fed to Express More Confidence that Policy is Sufficiently Restrictive Despite the Easing of Financial Conditions

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Marc Chandler
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Commentary will resume with a 2024 outlook on December 29. 

Overview: The dollar is trading with a firmer bias today ahead of the outcome of the FOMC meeting. Standing pat for two meetings was framed as a pause, but given the decline in price pressures, being unchanged for a third meeting is understood as the end of the historically aggressive tightening cycle. Fed Chair Powell is expected to express greater confidence that policy is sufficiently restrictive to bring inflation back to target. Trading after the FOMC meetings has been treacherous, with the markets often reversing initial moves. 

The rally in the S&P 500 to its best level since April 2022 failed to boost Asia Pacific equities today. Among the large markets, Japan, Australia, and Taiwan did manage to gain slightly. Europe's Stoxx 600 is about 0.25% higher to recoup yesterday's slippage. US index futures are trading with a firmer bias. Benchmark 10-year yields are lower. The 10-year JGB yield is off three basis points to 0.68%, a little above a three-month low. European yields are mostly 3-4 bp lower, with the disappointing UK October GDP sending the 10-year Gilt yield down nine basis points to also a three-month low near 3.87%. The US 10-year Treasury yield is almost two basis points lower at 4.18%. Gold is recovering after dipping to $1973, its lowest level since November 20. January WTI extended its decline to $67.70, which it has not seen since June, before stabilizing.

Asia Pacific

Japan's Tankan survey showed a slight improvement in sentiment across the small and large manufacturers and non-manufacturers. Sentiment among large manufacturers improved for the third consecutive quarter, while sentiment among non-manufacturers rose to the best level in almost three years. Capex plans were largely maintained (13.5% vs. 13.6%). The results reinforce the sense that after contracting in Q3, the Japanese economy is returning to growth this quarter. Separately, Prime Minister Kishida is expected to announce a cabinet re-shuffle tomorrow in response to the finance scandal in the faction that former Prime Minister Abe led.

Australia reports November jobs data tomorrow. The one statistic that captures the slower growth in the labor market is not job growth per se. Australia has averaged 36.5k jobs a month this year, down from the 46.3k average in the first ten months of 2022. More dramatic have been the slowdown in full-time job creation to a 16.1k average this year compared with a 48.7k average in the same period last year. The participation rate has been bounced between 66.7% and 67.0% this year and was at the upper end in October. Similarly, the unemployment rate been in a 3.5%-3.7% range this year and was at the lower end in October. A disappointing report could spur the market to bring forward the first cut, which is not fully priced into the futures market until next November. In fairness, there is an 80% chance that last month's hike is unwound by the end of Q3 24. 

The dollar was sold after the US CPI report yesterday and recorded a low near JPY144.75, a few ticks below Monday's low. It rebounded but stalled around JPY145.85. In regional trading today, the greenback held mostly above JPY145.20. The greenback saw a high near JPY146.60 on Monday, JPY146.20 yesterday, and about JPY146 today. It looks set to consolidate in North America ahead of the FOMC outcome. The Australian dollar traded on both sides of Monday's range yesterday, the technical significance of the outside day was neutralized by the settlement (~$0.6560) was within Monday's range. Today, it has been confined to about $0.6540-70, the lower part of yesterday's range. Nearby resistance may be around $0.6580. A move above $0.6620 lifts the tone, but barring that, with the momentum indicators trending lower, it may need to re-test last week's low near $0.6525. The US dollar is firmer against the Chinese yuan but within the range seen in the last few two sessions. It is rising for the seventh time in past eight sessions. Trading seemed unaffected by news that while lending picked up in November (CNY2.45 trillion from CNY1.845 trillion), it was a little less than expected. The improvement was roughly split between banks and shadow banks. The PBOC set the dollar's reference rate at CNY7.1126 (CNY7.1124 yesterday). The average in Bloomberg's survey was CNY7.1732.

Europe

Four European central banks meet tomorrow. The Swiss National Bank and Norway's Norges Bank will announce first. The swaps market is fully discounting the first SNB cut in Q2 next year. Two cuts in 2024 are priced in and around half of third cut is discounted. The SNB said in September that in the "current environment" it would also consider actions in the foreign exchange market, where it focused was on buying the franc. The franc has subsequently strengthened, and last week, it traded at its best level in eight years against the euro. Its reference to the exchange rate will have to be adjusted. Turning to Norway, the swaps market is pricing in the risk of one more hike before unwinding it in Q2 24. The pricing reflects expectations for about 100 bp in cuts next year. 

That brings us to the ECB and Bank of England. The latter has been successful in keeping interest rate expectations at bay. Still, today's October GDP was dismal, contracting by 0.3% (-0.1% expected) and unwinding September's 0.2% gain. Industrial production fell by 0.8%, services output declined by 0.2%, construction by -0.5%, and the trade deficit widened. Governor Bailey is likely to recognize the improvement in price trends but underscore that inflation is still elevated and that rate cut talk is premature. The swaps market has about 30 bp of cuts discounted by the end of H1 24 compared to about 18 bp at the start of the week.

Investors are focused on three elements of the ECB meeting. First is how the ECB President Lagarde responds to the aggressive pricing in rate cuts. The swaps market has slightly better than a 50% chance of a cut by the end of Q1 24. Two cuts are fully priced in by mid-year and about a 40% chance of a third. By the end of next year, the swaps market has priced in nearly 125 bp in cut. Second, are the updated forecasts that will partly shape Lagarde's comments and will be extended into 2026 for the first time. Inflation is falling faster than expected and next year's 3.2% forecast and 2025's 2.1% projections will likely be cut. A sub-2.0% (target) reading in 2025 or 2026 would be seen as a dovish signal. The ECB's GDP forecasts for 2024 and 2025 could also be revised lower from 1.0% and 1.5% respectively. The third element is about the balance sheet and in particular the reinvestment of maturing instruments from the Pandemic Emergency Purchase Program. The ECB's balance sheet has fallen from a peak of 69.5% of GDP (end of 2021) to 59.6% at the end of last year and to slightly more than 50% as of October. It was hovering a little below 40% of GDP before the Covid. Currently, the reinvestment of the maturing PEPP holdings is to run through the end of next year. There is speculation that the end can be brought forward, and the relevant working committees could be assigned the task of reassessing the timeframe. It would also be seen as a modest concession to the more hawkish members.

The euro reached about $1.0825 yesterday after the US CPI, stalling at the 200-day moving average. It fell back to about $1.0765, Monday's settlement before returning to the $1.08 area. The euro closed higher yesterday for the second consecutive session for the first time before the lower-than-expected eurozone CPI on November 30. The euro is consolidating so far today in a narrow quarter-cent range below $1.1800. Sterling posted an outside day, but its settlement was well within Monday's range, denying it much technical significance. Still, sterling found support above the 200-day moving average (~$1.2495) in recent days. However, the combination of slower wage growth and weak October GDP may see it yield today, and the next chart support may be near $1.2450. Sterling is trading at an eight-day low against the euro. The euro has scope for around another 0.5% gain toward the GBP0.8660 area.

America

What a reversal in sentiment in the last four months. September and October saw a sharp rise in rates. Higher or longer was the mantra. The bond vigilantes, we were told, were making a stand in the face of the large budget deficits and the deluge of Treasury supply. November and December have seen the yields reverse almost fully for the 10-year and even more for the two -year yield was tumbled to its lowest level since mid-June.

The Fed's statement is in needs of an update after leaving it nearly unchanged in November from September. The statement is likely to recognize that economic growth is moderating after a strong Q3. It can repeat its assessment that job gains have moderated but remain strong and recognize that unemployment continues to be low. The Fed will likely moderate its assessment that inflation remains elevated. It is, but the Fed also may speak more confidently about the direction. In November, the statement added "financial" to "credit conditions" that were tightening. Some of that tightening has abated. The statement's reference to "the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time..." will seem out of place as well. The unwinding of the Fed's balance sheet is seen continuing through at least mid-2024. 

The Summary of Economic projections will be updated. There seems to be more scope that median GDP forecasts can be shaved (1.5% 2024 and 1.8% for 2025 and 2026) than to be increased. That, in turn, would suggest that the 4.1% unemployment rate in 2024 and 2025 and 4.0% in 2026 could be revised a little higher. The September projections were for the headline PCE deflator to fall to 2.5% in 2024, 2.2% in 2025 and reaching 2.0% in 2026. The new median could trim next year's deflator but there seems to be less scope to cut outer years. The dot that gets the most attention, of course, is for Fed funds. In September, the FOMC thought two hikes for likely but have only delivered one. The 2024 projections anticipated two cuts, so net-net, one cut from current levels. The new median is projection may be consistent with three cuts in 2024. Some economists suggest that the first rate cuts will not be really easing monetary policy, but rather keeping the level of restriction in the face of easing of price pressures. While this may be true on some level, the neutral rate and real rates are intellectual constructs over which there seems to be little agreement among economists. Inflation expectations are an important factor in the calculation, but as we noted yesterday, there are various ways to estimate inflation expectations. They range from around 2.4% to 3.1%. Because the rate cut would be justified on unobservable measures, the Fed's communication is all the more important. However, the risk is that when a cut is delivered, it will be seen as an easing of policy regardless of the framing that may be offered. 

Resistance near CAD1.3620 held yesterday, and that is where the 20-day moving average is found today. The greenback has not closed above that average in a month. Moving above it would target the CAD1.3660 area initially. A shelf has been forged in recent days near CAD1.3550. Below there, support is seen in the CAD1.3515 area (the 200-day moving average) and this month's low near CAD1.3480. Despite the stronger than expected Mexican industrial production (0.6% in October vs. flat expectations), the peso went nowhere. The dollar remains in the range set last Thursday (~MXN17.2670-MXN17.5420). It is in a narrow range today (~MXN17.3050-MXN17.35). Mexico's central bank meets tomorrow. In recent weeks, the central bank's comments have encouraged investors to expect a cut in Q1 24. However, last week's announcement of a 20% increase in minimum wage next year, may inject a note of caution. Brazil's central bank meets today and a 50 bp cut (to 11.75%) is the consensus.